Arbitrage

We celebrate business successes. In fact, we even go so far as to suggest (without necessarily having empirical evidence) that success in business correlates with intelligence, moral superiority and suitability for government service. At the same time, we make folk heroes out of some of our most notorious criminals (e.g., Alphonse Gabriel Capone) because of their successes in running illicit businesses. Curious, isn’t it?

Arbitrage – defined simply – is the business of buying and selling an item in two different locations (or two different forms) to take advantage of a pricing disparity: buy low and sell high. This is the basic principle behind essentially all trade; a seller tries to sell his product for more than he paid to acquire it. We love this. It is what makes capitalism work. And we admire the entrepreneurs who make it happen. Until we don’t.

The point at which we will stop admiring these capitalists and start considering them criminals isn’t always clear. But one of the best ways to estimate which side of that line an individual will be considered to stand probably consists of analyzing who lost money in the deal. One thing is certain; if the party that lost money is a government authority then that same party will spend significant resources labeling that capitalist a cheat (even if he or she is celebrated by people on the street).

A case in point is the recent indictment of Republic National Distribution Company and several of its employees in what the TTB refers to as a smuggling operation. Make no mistake, what is alleged (if true) constitutes illegal conduct – and smuggling is just as good (and salacious) a word as any for what was taking place. But what was really taking place? Arbitrage. The kind of behavior we profess to admire.

Here is what happened. In Maryland, the state excise tax for liquor is about $1.50 per gallon. Some 180 miles away (give or take) in the great state of New York the excise tax is about $7.44 per gallon – almost 5 times as high. In business terms, we would see this as the perfect opportunity for arbitrage. From a simple standpoint of logistics, it does not cost $5.94 per gallon to transport liquids from Maryland to New York. There is nothing about the natural resources of the two locations that makes it $5.94 per gallon more expensive to produce liquids in New York than in Maryland. And there is absolutely nothing that makes New York-bought liquor more valuable than Maryland-bought hooch. The difference consists entirely of the amount of tax extracted, or perhaps extorted, by the respective jurisdictions.

Recognizing this pricing disparity, some enterprising New York liquor retailers apparently (and wholly understandably) began looking for opportunities to buy their supply from Maryland vendors. Maryland-based Republic National Distribution Company took the orders and delivered the alcohol to Maryland retailers, where it was held until it was actually claimed by the New York retailers. When the New York retailers picked up the liquor, they paid the Maryland retailers in cash. The retailers then paid RNDC by check.

In case you’re not keeping track, let me sum up. A Maryland distributor received orders at its offices in Maryland. It filled those orders by delivering liquor to a Maryland address. It received payment for those orders in Maryland (on a check drawn on the account of a Maryland payor).

So are we to admire this intrepid capitalist? Not according to the TTB, the Department of Justice, the IRS or the New York State Department of Taxation and Finance. According to the TTB press release, this was a criminal activity. The authorities are seeking a money judgment of at least $9 million, and forfeiture of all proceeds from the transactions. In addition, RNDC and each of the individual defendants faces a fine of $250,000. If any individual is convicted in connection with the case, he or she will face up to a 20 year prison sentence.

What should we learn from this? Firstly, the case reinforces the notion that anything which could be characterized as stealing from the government can find you in a load of trouble. Secondly, however, we should ask the question of whether this might have happened without any criminal intent.

What if RNDC was simply trying to accommodate the needs of its customers? Isn’t that just good business? The allegations include the filing of Maryland state reports indicating that all liquor sold by RNDC in these transactions was intended for consumption in Maryland. That looks bad, but what if RNDC didn’t actually know that the liquor would be carted back to The Empire State? What if they thought it might be carried back to New York, but they didn’t know for certain? Alternatively, what if the goods were to be consumed in Maryland but the buyers suddenly developed a New York State of Mind? Would your answer depend on whether RNDC had a term in its PO that required the buyer to distribute the liquor solely in the state of delivery?

At some point, the answers to these questions may put the distributor in the position of being made to police the behavior of the retailer. Is that good policy?

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Published by Brian B. DeFoe

A business lawyer with an emphasis on assisting clients in consumer-facing industries, especially hospitality and retail. I have a keen appreciation for spirits, especially single-malt scotch whiskies (the peatier the better, please) and robust bourbons.
I live on Bainbridge Island, Washington with my wife, three sons and an ever changing menagerie. My practice is based out of Seattle.
View all posts by Brian B. DeFoe